Option-Based Bankruptcy Prediction

University of Cyprus - Department of Public and Business Administration; King's College London; Massachusetts Institute of Technology (MIT) - Sloan School of Management

Date Written: June 2000

Abstract

This study builds on option-pricing theory to explain business bankruptcy based on a sample of 139 matched pairs of bankrupt and control U.S. firms for the period 1983-94. Our results indicate that the primary option-motivated variables, such as firm volatility, play an important role in predicting default, one, two and three years prior to bankruptcy. When the model is extended to account for the probability of default on interest payments due at intermediate times prior to debt maturity (either due to voluntary equityholder default or due to cash flow problems), related profitability and cash-flow/liquidity variables are shown to have incremental predictive power, while the primary option variables remain statistically significant. Our theory-driven model has significant explanatory power and prediction ability in all years tested.